Is the US Economy Heading for Stagflation?

Irrespective of how Obama's media supporters try to spin it the unemployment
situation is grave and still deteriorating. This was not supposed to happen.
According to his economic advisors the situation would be disastrous unless
congress rushed through Obama's stimulus package. Dr. Christine Romer -- one
of Obama's chief economic advisors -- predicted unemployment would hit 8.8
per cent unless swift action was undertaken.

Well it was, yet the official unemployment rate now stands at 9.4 per cent
and it could exceed 10 per cent. (It would be 16.4 per cent if those workers
who have either given up seeking work or have taken a part-time job as a substitute
for full-time work were included in the unemployment figures). And its not
getting any better. During April and May manufacturing alone shed 310,000 jobs.
The chart below was produced by the blogger Innocent
Bystander and reveals just how way out Obama's economic advisors' predictions
are.

So much for his vaunted claim to have saved 150,000 jobs. None of this should
really surprise us. The economic models that Obama's advisors use are worthless.
The people who failed to predict the crisis are the same ones who claimed to
be able to accurately predict the rate of unemployment at any point between
now and the first quarter of 2014. Like all Keynesians Romer has no genuine
idea as to how the economy works. And all the time Romer spends pondering her
model unemployment rises along with spending and an unsustainable deficit.

Some commentators see a light at the end of the tunnel. They refer to the
fact that though the Institute for Supply Management's PMI shows that manufacturing
is still contracting it has nevertheless risen by 2.7 over the April figure.
I still have my doubts. The Obama administration is the most financially irresponsible
one in US history. His outrageous spending and borrowing will lead to ever
rising taxes (John Taylor estimates that balancing the budget, even in 10 years
time, would require a permanent 60 per cent tax increase) the ramifications
of which must inevitable bear down on economic recovery.

There are two forces at work here: the monetary one and the spending one.
Since last September there has been a massive and unprecedented monetary expansion
during which the monetary base doubled. That Bernanke has created an inflationary
time bomb has not eluded the markets. Yields on 10-year U.S. Treasury bonds
have been rising and the 30-year fixed mortgage rate exceeded its three-month
peak when it hit 5.64 on 7 June. It seems pretty clear that the markets are
factoring in an inflation premium.

So industry will find itself facing rising interest rates in the middle of
recession due to the Fed's desperate monetary policy. That's the anvil so to
speak. The hammer will be the need to compete against the government for funding,
adding even more pressure to rates. To top it off massive taxes are waiting
in the wings, including an Obama strike against capital gains. Industry will
indeed have much to thank Bernanke and Obama for.

All of this helps explain why the economy is not responding as expected in
response to the Fed's monetary policy. And monetary policy is what needs to
looked at. In any case, the idea that government spending from borrowings stimulates
economic recovery is nonsense, as the Great
Depression proves. There is also another factor that most commentators
ignore.

A number of readers have pointed out to me that the "productivity of debt" seems
to be falling, meaning that it requires more and more debt to get a given amount
of GDP. This phenomenon is no mystery to the Austrians. Time and time again
they pointed out that so-called pump-priming would require ever more injections
of money to stimulate economic recovery in order to overcome the accumulated
malinvestments that were not liquidated in previous recessions. What we need
to consider is whether the point has now been reached where the size of the
monetary injection needed to stimulate recovery is now so large that it results
in stagflation.

It used to be that recessions were accompanied by falling prices. Because
of this few people realised that though prices in general fell consumer prices
rose relative to producer prices. In other words, capital goods suffered the
greatest price declines. Now that central banks inflate to prevent price declines
we can find ourselves in a situation where consumer prices are rising faster
than producer prices even as a large pool of unemployed emerges. This is stagflation.

The logic of this line of thought leads to the conclusion that a stagflationary
trend would be reflected in a weak demand for labour. As the money supply increases
unemployment still rises followed eventually by accelerating inflation. What
this means is that a point is reached where the level of unemployment rises
for each consecutive recession and where bringing it down requires greater
amounts of monetary injections. The following table is from the Bureau of Labor
Statistics.

The left hand side of the chart is the percentage of unemployed and the bottom
is the period 1990 to 2009. Note that in 1992 unemployment peaked at 7.8 per
cent. The next recession saw unemployment peak at 6.3 in 2003. (I believe that
by cutting the capital gains tax by 33 per cent and the tax rate on corporate
dividends by more than 50 per cent President Bush reversed the rise in unemployment).
The current recession has the official unemployment rate at 9.4 per cent and
rising. This is very worrying

Inflation works its black magic by widening firms' price margins thereby causing
them to expand output. Considering the present monetary situation and Obama
and the congressional Democrats' destructive tax, energy, regulatory, borrowing
and spending policies I cannot see where a widening of price margins -- if
they do occur -- can bring about a sustained recovery.

People do not seem to realise that the other term for economic growth is capital
accumulation. There is absolutely nothing in Obama's economic program that
will cause the capital structure to expand. On the contrary, everything points
to a contraction. This means that real wages and living standards would have
to fall.